FASB proposes simplifications to the issuer’s accounting for convertible instruments and contracts on an entity’s own equity has been saved
FASB proposes simplifications to the issuer’s accounting for convertible instruments and contracts on an entity’s own equity
This Heads Up discusses the FASB’s recently issued proposed Accounting Standards Update (ASU) that would simplify the accounting for certain financial instruments with characteristics of liabilities and equity, including convertible instruments and contracts on an entity’s own equity. The proposed ASU is part of the FASB’s simplification initiative, which aims to reduce unnecessary complexity in U.S. GAAP.
On July 31, 2019, the FASB issued a proposed ASU that would simplify the accounting for certain financial instruments with characteristics of liabilities and equity, including convertible instruments and contracts on an entity’s own equity. The proposed ASU is part of the FASB’s simplification initiative, which aims to reduce unnecessary complexity in U.S. GAAP. Comments on the proposed ASU are due by October 14, 2019.
Background and Key Changes in the Proposed ASU
Current U.S. GAAP
Navigating the guidance in U.S. GAAP on the issuer’s accounting for convertible debt instruments can be challenging since there are multiple disparate sets of classification, measurement, and derecognition requirements whose interactions are complex.
The guidance in U.S. GAAP contains five accounting models for the allocation of proceeds attributable to the issuance of a convertible debt instrument. These models and the proposed ASU’s modifications are described below.
|Instrument||Allocation Approach||Allocation Objective||Approach Retained Under Proposed ASU?|
|Convertible instrument with a bifurcated embedded derivative||With-and-without method. The embedded derivative is measured first at fair value, and the residual amount is allocated to the host contract.||To measure the embedded derivative at fair value in a manner similar to a freestanding derivative instrument||Yes|
|Traditional convertible debt||No separation. All proceeds are recorded as debt.||To reflect the mutual exclusivity of debt repayment and conversion option exercise (i.e., both cannot happen)||Yes|
|Convertible debt issued at a substantial premium||With-and-without method. The debt is measured first at its principal amount, and the residual amount is allocated to equity.||To record a substantial premium received in equity||No|
|Convertible debt with a cash conversion feature (CCF)||With-and-without method. The nonconvertible debt component is measured first at its fair value, and the residual amount is allocated to equity.||To reflect interest cost that is paid with the conversion feature||No|
|Convertible instrument with a beneficial conversion feature (BCF)||With-and-without method. The BCF is measured first at its intrinsic value and allocated to equity, and the residual amount is allocated to the host contract.||To record the intrinsic value of the conversion feature in equity||No|
Connecting the Dots
For an in-depth discussion of the application of the existing separation models in ASC 470-20,2 see Deloitte’s A Roadmap to the Issuer’s Accounting for Convertible Debt.
In response to feedback received from stakeholders regarding the complexity of current guidance, the FASB decided to seek to simplify the accounting for convertible instruments and enhance related disclosure requirements to improve the “usefulness and relevance of the information being provided to users of financial statements.” The proposed ASU’s significant amendments are described below.
Remove Separation Models in ASC 470-20 for Convertible Instruments
The proposed ASU would remove the separation models in ASC 470-20 for (1) convertible debt issued at a substantial premium, (2) convertible debt with a CCF, and (3) convertible instruments with a BCF. As a result, no embedded conversion features would be separately presented in equity under ASC 470-20. Instead, a convertible debt instrument would be accounted for wholly as debt and convertible preferred stock would be accounted for wholly as preferred stock (i.e., as a single unit of account) unless a convertible instrument contains features that require bifurcation as a derivative under ASC 815.
Connecting the Dots
The application of the existing separation models in ASC 470-20 involves the recognition of a debt discount, which is amortized to interest expense (for convertible instruments with a BCF or CCF), or the recognition of a debt premium in equity (for convertible instruments issued at a substantial premium). The elimination of these models would reduce reported interest expense and increase reported net income for entities that have issued a convertible instrument within the scope of those models.
Incremental Disclosure Requirements About Convertible Instruments
The proposed ASU would require an entity to provide expanded “disclosures about the terms and features of convertible instruments,” how the instruments have been reported in the entity’s financial statements, and “[i]nformation about events, conditions, and circumstances that can affect the assessment about the amount or timing of an entity’s future cash flows related to those instruments.” Examples of such disclosures include:
- The “pertinent rights and privileges of each convertible debt instrument outstanding,” such as the parties that control the conversion rights, settlement methods (e.g., cash or shares), and terms that may change conversion or exercise prices (excluding standard antidilution provisions).
- For contingently convertible instruments: (1) “[e]vents or changes in circumstances that would adjust or change the contingency or would cause the contingency to be met,” (2) “[i]nformation on whether the shares that would be issued if the contingently convertible securities were converted are included in the calculation of diluted earnings per share (EPS) and the reasons why or why not,” and (3) “[o]ther information that is helpful in understanding both the nature of the contingencies and the potential impact of conversion.”
- For convertible debt instruments: (1) the unamortized premium, discount, or issuance costs; (2) the net carrying amount; (3) fair value information (public business entities only); and (4) information about reported interest expense, including the effective interest and the amount of interest recognized.
- Information about events or changes in circumstances during the reporting period that significantly affect conversion conditions.
- Number of shares issued upon conversion, exercise, or satisfaction of required conditions during the reporting period.
- “Maturities and sinking fund requirements for convertible debt instruments for each of the [following] five years.“
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